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Déjà vu

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27 March 2020

David Prosser looks at the recent suspension of open-ended property funds and the structural suitability of investment companies for illiquid assets and dividend payments.

Here we go again. Amid the COVID-19 panic on financial markets in recent weeks, a familiar story emerged, with many open-ended property funds once again forced to shut up shop. Amid this extreme volatility, they cannot be sure what their property portfolios are worth or be confident of raising the funds needed to meet redemption requests from investors.

When will we learn that open-ended funds simply aren’t appropriate structures within which to hold illiquid assets such as property? We’ve seen this saga play out time and again in recent years. And while regulators are – belatedly - introducing new rules on suspensions that will come into force in September, these won’t tackle the underlying structural problem.

It would be daft to suggest closed-ended investment companies offer some sort of panacea here. Clearly, the same doubts about portfolio valuations apply to every type of property fund. Shareholders in property sector investment companies have seen significant losses in recent weeks, with the shares in most such funds slipping to substantial discounts to underlying net asset values.

Crucially, however, investment companies do not face the same awful dilemma as their open-ended equivalents. Asset price volatility remains paper-based – no investment company will need to sell portfolio holdings to meet investors’ redemption requests. Nor are investors locked out of their funds for an indefinite period – those who need to take cash have been able to do so through normal daily dealings on the stock market, though it would be wise to avoid crystallising losses if at all possible.

It’s yet another reminder that fund structure isn’t a technicality of investing – a dry, theoretical consideration that can just be ignored. Much of the time, the practical differences between open- and closed-ended funds aren’t obvious or impactful, but that can change very quickly.

We’re about to see another example of this in the income fund space. As company after company slashes or cancels its dividend in response to the COVID-19 crisis, many funds currently offering decent yields will struggle to maintain their pay-outs to investors. That’s an even more unattractive proposition given the Bank of England’s remarkable decision to cut interest rates to just 0.1%.

Investment companies, however, offer some relief. Courtesy of their unique ability to retain income to build up dividend reserve funds, many will have surplus cash on which they can now draw in order to maintain pay-outs to investors.

The AIC’s publication in recent days of its annual “dividend heroes” list underlines just how valuable this can be. It features 21 investment companies that have raised their dividends in each of the past 20 years, including 11 whose record goes back at least 40 years, and four that have managed every year for at least 50 years. The best of these funds, in other words, have managed to raise their dividends through every disastrous period of recent times, from the oil price shock of the 1970s to the global financial crisis.

Again, fund structure matters here. For income-focused investors, as with their property-focused counterparts, investment companies have been able to provide crucial flexibility and stability just when it has been needed most.

None of which is to suggest that the investment company sector is somehow immune to the travails of the world. Many funds have taken very significant hits over the past few weeks; there is, no doubt, much more volatility to come. But in any story, ports of relative calm come into their own – and once again, investment companies look to be a good place to sit out this crisis.